Economic headwinds in the U.S. are blowing hard this year, steadily increasing the risk of a recession. This naturally raises concerns about credit quality in S&P Global Ratings' portfolio of borrowers.

For now, credit quality in our rated universe is proving resilient, whether looking at ratings actions, the net ratings bias, or defaults, which remain low. But signs of degradation in credit quality are rising. For example, the U.S. distress ratio reached 9.2% at the start of July, the highest level since October 2020, as investors price in their concerns about persistently high inflation and a potential slowdown in the world's biggest economy. As the cost of funding rises across the board and GDP growth falters, the question that looms is: When will the pressures become too much for corporate borrowers?

We know that large corporate borrowers have some cushion, with the maturity wall a few years out and debt-servicing costs still at historic lows. However, in the murkier world of private debt (direct lending), the ability of borrowers to weather this storm is less clear.

Public filings of BDCs provide one glimpse into direct lenders' portfolios of loans, most of which is private debt of middle-market companies. Unlike the broadly syndicated loan (BSL) market, direct lending is primarily a buy-and-hold market, and these borrowers may have had less flexibility to refinance debt and lock in longer term financing during the especially favorable financing conditions of recent years. As a result, rising LIBOR rates may affect them more directly.

In looking for insight, S&P Global Ratings Research assessed 70 BDC filings from the third quarter of 2021 through the first quarter of this year to gauge the pressures on the smaller side of corporate lending. As expected, there are similarities with large corporates, as both have grown tremendously in the past five years on the backs of credit-friendly market conditions and robust mergers and acquisitions (M&A). But the pressures of rising interest rates are apparent, and it's unclear how these smaller corporate borrowers will fare.

BDC Portfolios Are Growing

As with the broadly syndicated market, the BDC universe has boomed in the past few years of favorable financing conditions and growing demand for private debt. This bull market remained evident through the three quarters of our study as the number of borrowers and the total cost of portfolios steadily rose. On a borrower basis, our analysis estimates there were about 4,500 borrowers across the 70 portfolios at the end of the third quarter 2021, and this increased by about 8%, to 4,800 borrowers, at the end of the first quarter of 2022. At the same time, investments in these BDCs rose to $160 billion, from $142 billion–an increase of about 12%.

Loans are the majority of instruments in BDC portfolios, representing 83% of total value as of March 31. Bonds and equities account for 5% and 12%, respectively, of the total value, and cash and other instruments make up the balance. Not all the bonds and equities come from corporate borrowers--about 2% of the total are from investments in collateralized loan obligations (CLOs) or credit funds.

The loans are a mix of broadly syndicated and direct loans. Based on our assessment of PitchBook Leveraged Commentary & Data's (LCD's) coverage of the large corporate universe, we estimate that 25% (about 1,100 issuers) of the total value of these 70 portfolios comes from broadly syndicated borrowers. Relative to the loan universe in BDCs, broadly syndicated is about 30% of the total cost. Those BSLs appear in a number of BDC portfolios; about half of them are in more than one portfolio—much higher than the 30% comparable share for direct loans.

Ultimately, the makeup of the BDC portfolios reflects their fundamental purpose: to invest in middle-market companies that are in their startup or growth stages. The challenge that stands before them is navigating the next 18-24 months as interest rates rise and the economy looks set to slip into recession. Do BDC investments have the same cushions as large corporates: a delayed maturity wall and the ability to manage the rising cost of funds?

The Maturity Wall Is Closer For Direct Loans

For large corporates, the recent bull market has resulted in a long-dated maturity wall. Looking at the Morningstar/LSTA Leveraged Loan Index (LLI), 25% of maturities won't come due until 2025, and 50% won't mature until 2027.

Based on our analysis of direct loans in BDC portfolios (loans excluding those identified as broadly syndicated), the maturity wall for direct loans is somewhat closer--42% of maturities come by 2025. Half of direct loans mature by 2026--a full year before the LLI comparable.

Still, near-term maturities seem largely manageable--and without the pressure of a closer maturity wall--the concern shifts to the cost of funding and the ramifications of elevated inflation.

Managing The Rising Cost Of Funding Is Key

The cost of funding is a rapidly rising tide. In tandem with increasing costs of production because of inflation and energy costs, the stressors on corporate borrowers' financials are significant. LIBOR floors over the past few years have kept the cost of funding from hitting rock bottom. Now, as rates rapidly rise, they have given corporate borrowers time to adjust to the new interest rate environment. In addition, the transition away from LIBOR provides borrowers alternate methods of funding, some of which are far less credit risk-sensitive than LIBOR.

LIBOR is more important to the direct lending market than the broadly syndicated, of course, since as of this year, banks can no longer originate LIBOR-based leveraged loans. Within the direct lending world, LIBOR remains the primary base rate for floating-rate loans, but through the three quarters of our study, there was a marked shift to the secured overnight financing rate (SOFR) and sterling overnight index average (SONIA).

At the end of third-quarter 2021, 96% of the loans were based off LIBOR (based upon share of total cost), and less than 0.1% were based on SOFR on SONIA. By the end of first-quarter 2022, the share of LIBOR had dropped to 90%, and that share had shifted to SOFR (almost 6%) and SONIA (approaching 1%).

Table 1

Loans have another year to complete the transition away from LIBOR before the deadline on June 30, 2023. However, borrowers must manage the cost of funding in a rising-rate environment. Through the three quarters of our analysis, the average all-in cost of funding for loans has remained relatively steady at a 5.9% spread and 7% all-in rate for LIBOR-based tranches (table 2). But the floors largely mask the effect of rising interest rates.

Our analysis of the BDC portfolio indicates there are floors in about 90% of LIBOR-based loans (based upon total cost), and 90% of those floors are 1% or less.

We estimate as of March 31, the end point of our data set and just more than a month into the Russia-Ukraine military conflict, that 8% of all floors were already breached. Additionally, if we look at share of breaches by floor, we see the pressure from the rising tide of LIBOR. For loans with floors of 25 bps, 22% of floors were breached, while only 8% of floors were breached for loans with floors of 100 bps.

The degree of breach was greatest at the lower floors. On average, the breach for 25 bps floors is 15 bps, dropping to 11 bps for 50 bps floors and just 2 bps for 100 bps floors (table 2).

With the three-month LIBOR above 2.5% at the end of July, essentially all floors will be breached. The focus now turns to how much pressure this puts on borrowers in the direct lending market, especially since the floor cushion has diminished.

Table 2

That said, even when the floor is breached, an increase in the benchmark rate doesn't flow through to an immediate increase in the borrower's rate. The process of rolling over tranches is as much an art as a science. It doesn't happen automatically: When a contract ends, the administrator can assess not only the duration of the next LIBOR contract but also base rate alternatives such as PRIME and SOFR. In addition, as of March 31, some LIBOR contracts in place reflect rates from 90 days prior, so the effect of a rising LIBOR is delayed because it depends on the expiration of the underlying contract.

In coming months, the few remaining floors will be breached, and the effect of the rising cost of borrowing will inevitably hit borrowers' bottom lines as LIBOR contracts end and higher rates take effect in the next contract. It will be interesting to see as the next round of BDC filings is released how borrowers will use the base rate options to manage the cost, and as the option to move to SOFR is available, how many will go that route.

The transition to SOFR, SONIA, or other alternative benchmarks from LIBOR further complicates the analysis of the extent to which rising rates will affect direct lenders. In this analysis, the all-in rate based off of SOFR aligns with the all-in rate based off of LIBOR. As of March 31, the average all-in rate for LIBOR was 6.96%, versus 6.63% for SOFR (table 3).

Table 3

While LIBOR and SOFR have largely held at comparable levels this year, these rates have shown marked divergences in prior periods, because there are fundamental differences. Unlike LIBOR, SOFR isn't a credit-sensitive rate (though the market provides for the ability to incorporate a credit-sensitive adjustment for SOFR rates), so the costs of SOFR versus LIBOR aren't fully comparable based upon all-in rates alone.

Where Will The Headwinds Direct The Market?

The distribution of the private loans within lending platforms involving BDCs, private credit funds, and middle-market CLOs make it difficult to definitively track the level of risk in this market and how concentrated it is in portfolios. Direct loans are, of course, intrinsically smaller loans held by a small group of lenders. But does this mean that the risk is well diversified because there is low correlation among portfolios? Or does this mean that a recession will hit a lot of smaller borrowers across multiple portfolios?

Our analysis indicates that 68% of direct loans are held in only one BDC, 29% are held in two to five BDCs, and only 3% are held across more than five BDCs. In comparison, 53% of BSLs are held in only one BDC, 42% in two to five BDCs, and 5% in more than five BDCs (fundamentally, broadly syndicated is primarily held by CLOs and Prime Rate Funds so the diversification across all portfolios is intrinsically broader than direct loans).

Whether or not the intensifying economic headwinds pose an imminent threat to the private debt markets isn't yet clear--and that's a problem in itself. A lack of transparency and potential illiquidity are key risks of the growing private debt market; by definition, less information is available on private debt than on public debt. While the close relationship between lenders and borrowers means lenders have sufficient information to execute individual transactions, few are privy to the details. That may be fine, for now--but in an economy struggling to sustain its post-pandemic rebound, we expect some shakeout.